What is the separation property and why does it apply?

What is the separation property and why does it apply?

Expert Solution

Alternative -1. A separation property is a crucial element of modern portfolio theory that gives a portfolio manager the ability to separate the process of satisfying investing clients' assets into two separate parts.

The first part is the determination of the "optimum risky portfolio". This portfolio is the same for all clients. In one version, it has the highest Sharpe ratio. It is the construction of a universal portfolio that is kept separate from the individual needs of each client.

The second part is tailoring the use of that portfolio to the risk-aversive needs of each individual client. This is achieved through simulation of a given risk-return range by allocating the client's total investments partly to that universal portfolio and partly to the risk-free asset.

Alternative -2 in simple words "The property that portfolio choice can be divided into two independent tasks: (1) Determination of the optimal risky portfolio, which is a purely mathematical problem, and (2) the personal choice of the best mix of the optimal risky portfolio and the risk-free asset, which depends on a person's degree of risk aversion.

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